Mastering Inventory Valuation Methods | CFA Level I FSA
Welcome back, fellow finance enthusiasts! In this article, we’re going to explore inventory valuation methods and help you become a master at understanding them. We’ll be discussing the four main methods: specific identification, LIFO, FIFO, and average cost. Additionally, we’ll take a look at how companies record changes to inventory using either a periodic inventory system or a perpetual inventory system. So, buckle up and let’s dive in!
The Inventory Equation
Before we begin, let’s do a quick refresher on the inventory equation we learned earlier.
Ending Inventory = Beginning Inventory + Purchases – Cost of Goods Sold
The cost of goods sold (COGS) is calculated by multiplying the number of units sold by the unit cost that was capitalized when the inventory was purchased or produced. The challenge firms often face is determining which unit cost should be used, as inventory would have been accumulated over time at different capitalized costs.
To resolve this issue, firms must select a cost flow method to determine the cost of goods sold for the period. The four methods taught in the CFA curriculum are specific identification, first-in first-out (FIFO), last-in first-out (LIFO), and weighted average cost.
Understanding the Four Inventory Valuation Methods
Let’s refresh our memories on these methods using a simple example of a shoe retailer.
Let’s say the retailer already has a balance stock of 4 shoes, which were acquired at $80 each at the beginning of the period. The total capitalized cost of this inventory would be $320 in the balance sheet.
During the reporting period, 10 additional shoes were acquired at $100 each. The total capitalized cost of the inventory is now $1,320.
If 10 shoes were sold during this period, what would be the cost of goods sold?
1. Specific Identification Method
Under the specific identification method, each unit sold is matched with the unit’s actual cost. So, if the retailer can identify exactly which items were sold, it can use the specific identification method. By adding up the cost of each identified unit, we get a total of $960 cost of goods sold for this period. Specific identification is only appropriate for businesses that deal with a small number of costly and easily identifiable products.
2. First-In, First-Out (FIFO) Method
Under the FIFO method, the first item purchased is assumed to be the first item sold. The cost of the earliest items purchased flow to the cost of goods sold first. So, in this case, we consider the first 4 shoes with a cost of $80 each first, before considering the rest at $100 each. The cost of goods sold in this case is $920.
Notice that for this method, the ending inventory is valued based on the most recent purchases. This arguably provides the best reflection of the current cost of the inventory. Conversely, the cost of goods sold is based on the earliest costs. In an inflationary environment, the cost of goods sold will be understated compared to the current cost, resulting in overstated earnings.
3. Last-In, First-Out (LIFO) Method
Under the LIFO method, the last item purchased is assumed to be the first item sold. The cost of the most recent items purchased flow to the cost of goods sold first. So, in this case, we consider the 10 shoes with a cost of $100 each first. The cost of goods sold in this case is $1,000.
Notice that for this method, the ending inventory is valued based on the earliest purchases. This does not necessarily provide the best reflection of the current cost of the inventory. Conversely, the cost of goods sold is based on the most recent costs. In an inflationary environment, the cost of goods sold will be higher compared to FIFO, resulting in lower earnings.
4. Weighted Average Cost Method
Under the weighted average cost method, the average cost of all items in inventory is used to determine the cost of goods sold. To calculate the average cost, we divide the total cost of the inventory by the number of units. In this case, the total cost of inventory is $1,320, and there are 14 shoes. Therefore, the average cost per shoe is $94.30. The cost of goods sold for 10 shoes is then $943.
Notice that for this method, both the ending inventory and the cost of goods sold are valued at the same average cost per unit. This method smooths out the impact of changes in costs over time and minimizes the effect of unusual fluctuations.
Periodic vs. Perpetual Inventory Systems
In addition to the inventory valuation methods, it is essential to understand the two main systems for recording changes to inventory: the periodic inventory system and the perpetual inventory system.
1. Periodic Inventory System
Under a periodic inventory system, a company only updates its inventory records at the end of an accounting period. During the period, the company records all purchases and returns in a purchases account. At the end of the period, the company calculates the ending inventory and cost of goods sold using one of the inventory valuation methods discussed earlier. This system is less accurate, as it does not track inventory in real-time, but it can be less expensive and more straightforward to implement.
2. Perpetual Inventory System
Under a perpetual inventory system, a company updates its inventory records continuously, as transactions occur. When items are sold, the cost of goods sold is calculated and recorded immediately using one of the inventory valuation methods. This system provides real-time information about inventory levels, which can help with inventory management, sales forecasting, and theft prevention. However, it requires more sophisticated software and accounting systems, making it more expensive to implement.
Understanding inventory valuation methods and the different inventory systems is crucial for financial analysts, as they play a significant role in determining a company’s profitability and financial health. By mastering these methods, you will have a solid foundation to tackle inventory-related questions on the CFA Level I FSA exam and will be well-prepared for your future career in finance.